Article: Keep track of volatile oil prices

Oil is in the spotlight once more amid speculation over a production freeze and the price returning to the $50 per barrel level. Exchange-traded products (ETPs) – including higher octane short and leveraged ETPs – can provide a way for investors to play this price volatility. Ministers from production cartel OPEC are set for an informal meeting during an Algerian energy conference from 26 until 28 September and there have been hints at some kind of agreement. Having been in a technical bear market in early August, oil price pushed above $50 on 18 August 2016. The main obstacle to any deal is likely to be Saudi Arabia which has continued to pump oil at record rates in an attempt to take back market share from US shale producers, a strategy which appears to be having only limited success. Research from WisdomTree shows short oil ETPs produced big returns as a result of a crash in the crude oil price in July 2016. Boost WTI 3x Short Daily ETP (3OIS), for example, returned 52% compared to benchmark returns of 15.2%. The exchange-traded product specialist also noted: ‘Oil succumbed to renewed fundamental weakness in July as futures prices crashed by over 15%. This reversal in investor sentiment is evident from strong outflows of $2.4 billion from oil ETCs (exchange-traded commodities) since March, a stark contrast to earlier inflows of $2.6 billion at the start of the year.’ ETP table

CONTANGO  AND  COMPOUNDING

Commodities are largely traded in futures contracts. The purchase or sale of a commodity is agreed at a fixed price for delivery on a specified date – typically either one month, three months or six months out. This facilitates the buying and selling of said commodity without having to take physical delivery of a barrel of oil or bushel of corn. Only a tiny fraction of these contracts are settled through deliveries with the remainder ‘rolled over’ to the next month. Contango refers to the market condition where the price of a futures contract in a commodity is trading above the spot price. Backwardation describes the reverse – where futures are trading below the spot price – often because of short-term tightness in the underlying market. Arguably contango is a more natural state as it reflects costs of ownership such as storage and insurance. What does this mean for an oil exchange-traded product? When the product rolls contracts in order to avoid taking delivery of the physical asset, contango sees returns diminished. This is also known as ‘negative roll yield’. Backwardation sees returns enhanced due to the ‘positive roll yield’. The impact of contango is more acute for investors in ETPs because, unlike other passive investors, the providers of these products do not pay a premium every month to cover the cost of the roll and maintain the same position. In effect the instrument is giving up a proportion of its position to cover the cost of the roll. Separately compounding, with most leveraged and short products based on the daily return from an index, can also have an impact on returns. Fellow exchange-traded product specialist Boost summarises how this compounding works: ‘Daily compounding may lead to returns that are greater or less than the sum of the individual daily returns. ‘The compounding effect can positively enhance returns in trending markets (upward or downward) while negatively impact returns when the markets are more volatile or trade sideways for long periods.’